Fitch: Structured Repos Signal Market Appetite, Liquidity Risks

According to Fitch, investor appetite for legacy, distressed structured finance securities continues to drive their acceptability as repo collateral.

Fitch said its analysis of repo collateral trends, which covers the most recent Form N-MFP reporting period of end-May 2012, reveals that lower quality securities still predominate the collateral pools backing structured finance repos, with Countrywide, Bear Stearns, Lehman, and Washington Mutual ranking among the ten largest issuers of structured finance repo collateral.

In terms of overall volumes, Federal Reserve Bank of New York (FRBNY) data indicates that roughly $75 billion of structured finance securities were financed through tri-party repos as of July 2012. Funding these less liquid, more volatile securities through short-term, wholesale borrowing poses potential liquidity risks to both repo market participants and the broader structured finance market, Fitch said.

Fitch noted that since the beginning of this year, several trends point to improved liquidity and market demand for legacy structured finance securities. Notably, the FRBNY conducted several successful “Maiden Lane” auctions of crisis-era mortgage-backed securities (MBS) and collateralized debt obligations (CDO). Based on the FRBNY’s quarterly review of asset sales, during the first half of 2012 aggregate “Maiden Lane” asset sales topped $27 billion, versus about $18 billion in asset sales during all of 2011. Additionally, legacy MBS securities prices have rallied since the beginning of the year.

For both investors and financial institutions, the persistent low-yield environment has likely played a pivotal role in stimulating appetite for these riskier securities. The repo market has provided investors with the opportunity to fund these distressed, lower quality exposures at relatively low cost. According to Fitch’s analysis, repos backed by structured finance collateral generated a median yield of 65 basis points as of end-May 2012, which represents the cost of funding for dealer institutions that access the tri-party market as repo borrowers.